In case you are wondering, "D" is my husband -- Dave Liu! As you've probably noticed, I don't update this blog often but I may post more as I've linked this to my Google+ account.

Sunday, April 27, 2003

Burgernomics: Macroeconomics for Dummies

I have had an aversion to macroeconomics (microeconomics I'm cool with) for as long as I can remember. All the books I have encountered have an exceptionally high "snooze" factor (even for a textbook) which prevented me from slogging through the material and learning it. I did take a macroeconomics course at MIT Sloan, but I was too light on theory to really appreciate Lester Thurow's highly entertaining lectures (and I don't recall any theory being taught in that class).

Although I'm regretting the decision now, it seemed like a good idea at the time, so I applied to take the CFA Level I exam this year. Based on a friend's recommendation, instead of buying half a dozen overpriced textbooks to read a handful of chapters on various topics, I purchased a set of Schweser study guides instead. Each study guide summarizes "must know" information and provides sample review questions. They're excellent. And guess what? They have a study guide on macroeconomics! Exactly what I was looking for. Of course, now that I've read the material and finally get it, it has dawned on me why I abhor the subject. It's because there are several competing theories on macroeconomics, and even after decades (and possibly centuries) of debate, there is no right answer to what a government's fiscal policy should be, or now markets should (or should not) be regulated. To an engineering-minded person like myself, the concept of "there is no answer" is unacceptable!

If you have similar negative feelings towards macroeconomics, I'd like to refer you to The Economist, which publishes a Big Mac Index every year. It's a fun way to learn about purchasing-power parity, and provides a method of determining whether a country's currency is correctly valued. The Economist calls it "Burgernomics". According to the THEORY of purchasing-power parity, in the LONG RUN (all these caveats and disclaimers when it comes to macroeconomics), exchange rates should move twards rates that would equalize the prices of an identical basket of goods and services in any two countries. In Burgernomics, The Economist's "basket" is a McDonald's Big Mac, which is produced in 118 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.

As I emphasized in the previous paragraph, this is theory only. In reality, the model is flawed because

...Big Macs are not traded across borders as the PPP theory demands, and prices are distorted by taxes, tariffs, different profit margins and differences in the cost of non-tradables, such as rents."

Li Lian Ong of the International Monetary Fund even wrote a whole book on the index. She says that the Big Mac Index is quite accurate in tracking long term exchange rates, but there are "persistent deviations from PPP", and highlights the fact that "emerging-market currencies are consistently undervalued", perhaps due to differences in productivity:

Rich countries have higher productivity than poor countries, but their advantage tends to be smaller in non-tradable goods and services than in tradables. Because wages are the same in both sectors, non-tradables [Lauren's Note: Big Macs are non-tradable] are cheaper in poorer countries.

So what are the results and predictions for this year based on the Big Mac Index?

The Chinese yuan is the most undervalued (their burgers cost $1.20) and the Swiss franc the most overvalued (their burgers cost $4.52). Compare this to the average price of a Big Mac in the U.S. which is $2.71.

The euro is overvalued against the USD.

The Australian dollar is likely to see the biggest gain.

The British, Swedish and Danish currencies are significantly overvalued against the euro. The pound will fall further against the euro.

China will come under increasing pressure to revalue the yuan

Pretty neat, huh? There's a whole section on foreign exchange in CFA Level I, so it will definitely help me there. All this talk of burgers is making me hungry too...